The Hidden Challenges of Starting a Company in Secondary Markets

Fred Wilson’s much debated post, Second and Third Tier Markets and Beyond, sparked an important discussion about operating and investing in businesses outside of the Valley. Case in point: within 48 hours, the piece generated a heated Twitter exchange (including input from the one and only Bill Gurley), a Pitchbook analysis of the best M&A outcomes by region, and even a capitulation of sorts from Fred. Wilson identified a couple of important challenges of building in these markets, namely lack of conviction, lack of money, lack of infrastructure, and shallower talent pools:

But there is a dynamic that goes on in these third tier markets where the local investors look to investors in the first and second tier markets to come down and “validate” their investments. And the investors in the first and second tier markets won’t come down and do that without a strong local lead. This game of “chicken” happens ways too often in these markets and is incredibly frustrating to entrepreneurs in these markets. These third tier markets need a few strong Series A focused VC firms who have large enough fund sizes to be aggressive lead investors and also have the conviction and stomach to play that game. That is what USV, and Flatiron before it, did in NYC. That is what Foundry did in Boulder. That is the game Upfront is playing in LA. Every third tier market needs a few VC firms like that. And being that investor is a terrific way to make a lot of money.

The truth is you can build a startup in almost any city in the US today. But it is harder. Harder to build the team. Harder to get customers. Harder to get attention. And harder to raise capital. Which is a huge opportunity for VCs who are willing to get on planes or cars and get to these places.

And his insights are a good start. But as someone who’s lived the Chicago startup scene since moving here in 2007 to help build CardRunners Gaming, I’d like to suggest three other non-obvious challenges of building companies in secondary or tertiary markets. This is a tough love blog intended to provide guidance within secondary markets and enable founders to actualize their potential. If you can get through it and internalize it, it’ll make you stronger.

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The Press Challenge

Although the press outside of SF & NY may not be bulge bracket publications, they are nevertheless not constrained either by distribution (digital solves that), nor by space. But they are constrained by a dearth of quality stories. Meaning that Chicago, for example, has a finite number of private unicorns or venture backed IPOs – so, if you want a quote from the CEO of a Chicago unicorn company for example, you've got finite people to call.

The effects are that it can force a cycle of manufactured, often unwarranted positivity, feature stories, even local awards on companies that are downright unproven or even floundering. Moreover, it enables certain founders, especially those with a natural PR inclination, to run from magazine shoot to newspaper interview to conference to panel and back, all the while ignoring the actual company they’re supposedly running. It’s akin to Mark Suster’s admonition to Be Careful Not to Become a Conference Ho: “If you’re a startup CEO — don’t kid yourself. Get back to work. There’s a team in the office in need of your guidance.” But that warning is amplified in secondary markets where founders – sometimes entirely unproven, even occasionally on the brink of shutdown – are paraded around by the press, conference organizers and awards shows as local heroes.

PR is a wonderful tool and an extraordinary opportunity for the right situations (building a story for hiring, consumer marketing, etc). But it is a challenge to ignore the phone when the press circuit is continually calling. Local founders must learn to say no at the formative stages of their business.

The Self Delusion Problem

If an entrepreneur goes to raise money in the Valley and is unsuccessful they are forced to concede one of the following points: either (a) I am not a good fundraiser or storyteller, (b) This should not be a venture backed business*, (c) I have not proven sufficient traction, or (d) This is not a good idea period. [There may be other nuances or derivatives of these four, but you get the idea.]

This is because the Valley funds over a thousand new companies annually, plays host to hundreds of seed stage funds, and has the deepest network of angel investors anywhere in the country. Lots of companies get funded and you didn’t.

But in Chicago, an entrepreneur can ignore all of those failings and instead simply blame Chicago: It is Chicago with its low risk tolerance, or its culture of demanding revenue, or its disposition towards boring enterprise businesses, or excuse Z that are the reason my company didn’t get funded.

Unfortunately, some businesses with outsized potential certainly do fall through the cracks in smaller markets (Fred alludes to this as well). But that simply serves to reinforce the potential for self delusion: wherein founders, should they so choose, never need to admit that their startups do not meet the threshold for investment. This can enable a cycle where local founders become resentful and/or spend years fundraising for a business that will simply not get funded.*

The Cap Table Problem

A big pitfall of secondary markets is poor cap table planning and management from the earliest stages that materially affects long-term growth potential. It typically falls into one of two buckets:

(1) We have met multiple companies that were otherwise intriguing except for the fact that a single investor (often an angel) owned more than 50% of the company. This matters because with an option pool, and 25% dilution of the impending financing, it leaves even a solo founder (let alone a 3-person founding team) improperly aligned for future growth needs.

(2) A company that initially raised money from angels at too high of a valuation, that later took on a bridge or even a fresh round of capital from that same group of angels (again, at a higher valuation). SO, by the time the company had proven product/market fit, it’s prior valuation was dislocated from the market values traditionally ascribed by venture institutions.

#2 is a far more egregious problem, often generating a vicious cycle of dependency on amateur investors. Now, to be fair, every market suffers from questionable practices of non-professional investors. But those practices are exaggerated in secondary markets that lack pre-seed infrastructure or successful entrepreneurs to properly seed the next era of startups.

In almost all markets, even ones without much institutional venture, there are copious numbers of high net worth individuals, successful real estate operators, or financial services pros who are looking to enter startup investing – either because they can’t generate alpha in their core jobs or because startups are sexy.

The problem is this: once the vicious cycle of dependency has been initiated (and because no one has an interest in marking down their investments) it is extremely difficult to disassociate from it. Which isn’t to say that great companies won’t be built with such a founding structure. Many have. But it does make it difficult to attract experienced local entrepreneurs or traditional institutions to the cap table.

Summary

Secondary and tertiary markets provide a lot of benefits for startups looking to build great businesses. Lower costs of living enable a lesser burn rate. Less competition for great talent and easier accessibility to successful advisor networks are also a big positive. That I am very bullish on Chicago should be obvious: despite being an East Coaster (DC & NYC) – and with opportunities in numerous cities - I’ve made it my new home.

But pitfalls and challenges abound. The better informed entrepreneurs are, the better non-SF markets are likely to perform.

* My intention is not to be crass or insensitive. There are many great businesses, digital and offline, that are simply not a fit for institutional venture funding. My first startup, CardRunners Gaming, is one such company – profitable from day one and profitable now, even a decade later, although it’s total market potential was at most $10M. Had the company raised institutional money, it would have imploded upon itself trying to stimulate growth in a market that simply could not accommodate it.

Thankfully, other investors such as Bryce Roberts at Indie.vc are building innovative funding models, intended to accommodate non-venture digital businesses. Here’s a great article on their efforts: Venture Capital and Its Discontents